While there are innumerable theories on the best remedy for the current financial crisis, there is agreement on one point, at least: increased transparency is good. We look at a provision from the last round of financial regulation, the Sarbanes Oxley Act of 2002 (“SOX”), which imposed disclosure requirements tailored to prevent some of the kinds of abuses that led to the downfall of Enron. In response to Enron’s self-dealing transactions, Section 406 of SOX required a public company to disclose its code of ethics and to disclose immediately any waivers from that code the company grants to its top three executives. These waivers offer a unique window not only into ethical practices at public U.S. companies, but also into how disclosure works “on the ground” –whether companies are actually complying with disclosure rules and whether these rules prevent self-dealing transactions.
Out of 200 randomly selected firms, we found only one waiver over 4 years disclosed pursuant to Section 406. However, by exploiting an overlap in disclosure regulations, we were able to cross check our sample companies’ waiver disclosure. We find 30 instances where companies appear to be violating the law, and another 74 where companies evade illegality by watering down their codes to an arguably impermissible degree—their codes of ethics do not forbid the same Enron-style conflicts of interest that led to the adoption of Section 406 in the first place. Finally we study all waivers filed by all public companies with the SEC in the four years following SOX’s passage—and find only 36 total. Event studies reveal that the market generally does not react to these transactions, suggesting that companies only use waivers to disclose innocuous, immaterial information.
We draw two lessons, one specific, one general. First, the current regime is a bad one, long on costly and burdensome disclosure but short on demonstrable benefit. Section 406’s disclosure requirement is not functioning as intended. Either by mistake or manipulation, companies are evading its requirements and not providing information to the market. We suggest eliminating the code of ethics waiver disclosure requirements, and substituting a requirement of immediate disclosure of related-party transactions involving the CEO, CFO, and CAO. Second, our study casts light more generally on the limited utility of regulating by means of disclosure alone.